Convertible Bond Funds May Be Safe Haven

The stock-market selloff and interest rate uncertainty have many investors wondering where to stash their money. One oft-overlooked place is convertible bond funds.

"At this point nobody knows where the bottom is," says Edward Silverstein, portfolio manager of the MainStay Convertible ( MCOAX) fund. "During times like these, convertibles protect you on the downside and, when stocks eventually rally again, they allow you to join in the upside."

The S&P 500 is down 12.5% this year, while the average convertibles fund is off only 4.75%, according to fund tracker Morningstar. In the bull market of 2003, the average convertible bond fund returned 26.6%, compared with 28.7% for the S&P 500. In other words, converts delivered 93% of the upside of the stock market.

Meanwhile, when the stock market sank in 2002, convert funds fell just 8% for the year vs. 22% for the index, which is only 36% of the decline.

Silverstein's fund, down 4.8% this year, has returned an average of 8.5% annually over the past three years, over two full percentage points better than the average convertibles fund, and more than double the S&P's annualized return of 4.1%.

Convertible bonds, or converts, are part bond and part stock. They are typically three-year corporate bonds that pay interest but give you the option to take your principal in cash or a set number of shares of the issuer's stock at maturity (thus "converting" the bond to stock). The terms of the deal -- how much interest you earn, when the bond matures and how many shares of stock you can get at maturity -- are set when the company issues the bond.

For many investors, converts offer a way to invest in stocks with less risk, which isn't a bad proposition in today's scary market. When the bond is issued, the stock price you'll get at maturity -- the so-called conversion price -- is usually about 20% to 25% above the current price. If the stock is above the conversion price when the bond matures, convert holders end up getting the stock at a discount. On the other hand, if the stock sinks, you still get interest payments -- and the return of your principal at maturity.

Convert fund investors certainly have more to fear from a drop in stock prices than a spike in interest rates. That's because most fund managers shy away from holding too many busted converts -- those trading so far below their conversion price that they're effectively trading like bonds. These busted converts are susceptible to a rise in long-term rates.

If a convert manager holds too many busted converts, the fund will skew toward mirroring a traditional bond fund. At the other end of the spectrum, some convert funds are de facto stock funds because their portfolios are dominated by converts that are deep in the money. When a convert is deep in the money, the underlying stock is so far above the bond's conversion price that instead of the bond capturing only 70% of a stock's upside, it moves closer to 100%.

Due to the bull market in commodities, many of Silverstein's energy converts, like Schlumberger ( SLB) and Halliburton ( HAL), are deep in the money, trading like stocks.

"I bought most of these issues years ago, before the huge run-up in oil," says Silverstein. "Now energy converts are scarce, because they don't need to raise money this way."

Major U.S. banks, on the other hand, are desperate for money to shore up their balance sheets, selling converts with high coupons of up to 10%. Silverstein is underweight financials compared to his benchmark, the Merrill Lynch All-Convertibles Index.

"They are fundamentally impossible to analyze at this point, even the executives of these banks and brokers have no idea what's going on," says Silverstein, who owns Citigroup ( C) and Bank of America ( BAC) converts. "But at some point they will stabilize. In the meantime, we have downside protection and tremendous yields."

Speaking of outsized yields, Silverstein is collecting a 12% yield from troubled auto maker GM ( GM) while the stock continues to shrink on bankruptcy fears.

"GM is too big to fail from a manufacturing and employment perspective, not just auto jobs but the ancillary jobs in auto-plant cities," says Silverstein. "If the government can bail out Bear Stearns, the fifth biggest investment bank, - than it will certainly rescue GM and or Ford ( F). Those companies will not go away."

And in the meantime, he is getting paid to wait for a turnaround.

Before joining TheStreet.com, Gregg Greenberg was a writer and segment producer for CNBC's Closing Bell. He previously worked at FleetBoston and Lehman Brothers in their Private Client Services divisions, covering high net-worth individuals and midsize hedge funds. Greenberg attended New York University's School of Business and Economic Reporting. He also has an M.B.A. from Cornell University's Johnson School of Business, and a B.A. in history from Amherst College.